Current account interest - tax implications for UK and US?

I get a monthly interest from my current account in the UK from Lloyds.

1) Does the amount that show up in my bank account come pre-taxed already? If yes, how do I know if I'm paying the right amount of tax (i.e. the bank is taxing the right amount)? If no, do I get tax on it when I do my self-assessment?

2) What does the above imply for my US taxes? How is it reported (especially if Lloyds is only partially taxing it)?

Thanks!
 

1) When you receive £80 bank interest, this is £100 from which £20 of income tax has already been deducted. When you complete your UK self assessment your bank interest of £100 will be added to your other income, the tax computed, and then a credit of £20 will be deducted from the tax bill for the tax already paid.

However, things are due to change in April 2016. From 6 April, 2015 UK banks will start to pay interest without any tax deduction. People with income in the basic rate band (paying 20% marginal rate) will have a personal savings allowance (PSA) of £1,000 interest tax free, and those in the higher rate band (paying 40% marginal rate) will have a PSA of £500. If your bank interest exceeds your tax free allowance then you will pay the tax in your self assessment.

2) You report the gross interest amount of £100 on 1040 Schedule B. You can reduce or eliminate US tax on it by filing IRS Form 1116 (passive) to take a tax credit for the £20 of UK tax already paid, and any further tax you will pay on it if you are a higher rate tax payer.

As remarked above, from April 2016, you will have no UK tax liability for the tax free allowance of £1,000 or £500. Depending upon your total UK interest, you may or may not see US tax on your bank interest. For example, if you are a basic rate tax payer and have only £1,000 interest, there will be no UK tax, but you will need to pay US tax at your US marginal rate on that £1,000. If you are a UK basic rate taxpayer and have £2,500 bank interest, you will have £300 UK tax, on the £1,500 above your allowance, and that can be taken as a credit against whatever US tax you would pay on £2,500.

As you can see, it will be fairly complicated to figure out, for the purposes of taking a credit using IRS Form 1116, exactly what UK tax you have paid on your UK bank interest in calendar year 2016. However, if your total circumstances are straightforward and your bank interest is only a few hundred pounds, then Form 1116 is probably something you can do yourself.

Well done, RW, a good and thorough explanation.

There's also a bit of a tax free element to the US return in the form of the personal exemption and the standard deduction. Of course, it's not necessarily all straightforward, and individual circumstances can vary.

Thanks, RW. That's really clear and helpful advice. One quick clarification - are the taxes already paid on income and interest self reported (ie honor code) or are there UK forms that'll need to be submitted? Just wanted to check whether I can actually file in January or if I'll have to file for an October extension.

Thanks! 

Each UK bank will send you a statement of interest paid, sometime in late April through June. You can also usually find this amongst the documents that you can access on-line if your bank gives you on-line access (as almost all do these days). You have until 31 January 2017 to submit on-line your UK tax return for the UK tax year 6 April 2015 - 5 April 2016 (or until 31 December 2016 if on paper). You do not have to attach any statements from your bank. The UK operates an honour system. But you know that HMRC are receiving the same information that your bank is providing to you, so they can check your accuracy of reporting if they wish.

HMRC provide a easy-to-use on-line tool for preparing your UK tax return. So there is no need to buy any other software, unless you have very complicated affairs. You can register on their site and thereafter have an up-to-date accounting of what you have paid and owe. This is one of many areas in which UK's HMRC beats the IRS hands-down. (The UK government have even been talking of doing away with tax returns altogether, as they think that someday soon they will be able to collect all the necessary information automatically. I wonder if it is germane that in the US firms like TurboTax have a lobbying presence in Washington.)

As for reporting your bank interest on your US return - you do not need to file any paperwork from your UK bank. So you can do it in January - thought I think most people would wait until the automatic extension in July. Just keep a month-by-month spreadsheet and copies of bank statements. You can add up the 12 payments you have received for calendar year 2015, divide by 0.8, and then report that as your gross interest. Then on Form 1116 (ticked "passive"), you can take a tax credit for the 20% UK tax you have paid. If you are a higher or additional rate UK tax payer, then you will pay more UK tax on this interest, which can also be taken as a credit on Form 1116, though you might not actually pay that tax until you make a "balancing payment" in January 31, 2017. This is where things become difficult, because of two issues: the mismatch of US and UK tax years, and the fact that it is hard to say what tax the UK is actually charging on your interest, and at what date you paid it. Form 1116 expects you to work with either an "accrued" or "paid" basis. Most people use "paid". You can carry-forward and carry-back your UK taxes paid, but at the cost of accountancy complexity.

I have never really figured out the "right way" to handle the above issues on IRS Form 1116. There are experts reading this forum who know much more that I do and might like to chip in. However, one thing I have concluded is that when it comes to completing a US tax return one should stop obsessing that there is a "right way", and that black helicopters will descend if you fail to follow it. If you do something that you can defend, if you are audited by the IRS, as being a good faith attempt to pay the right amount of US tax then perhaps that is enough. For example, if you are a UK 40% rate tax payer you might just claim a credit for 40% UK tax paid on your interest on Form 1116, and leave it at that. With UK tax rates being greater than the US, it is unlikely you owe any US tax on your UK interest (unless some of that were to derive from a UK ISA account paying UK tax free interest).

You could hire a tax accountant who is expert in these things who will complete Form 1116 more correctly, in some sense, - but that could end up costing you vastly more than the few hundred pounds of interest you are might be trying to properly account for on your US tax return. One possibility would be to hire an accountant to help you for at least one year, as a way to learn a method. Another is to do the best you can, and then learn how to do it better if the IRS come back at you with identification of a mistake.

It was another contributor to this forum who once opined, - for the benefit of those who are in danger of being too obsessive -, that there is no unique right way to complete a US tax return.

RW - thanks again for another thorough, clear, and helpful response.

You're right - it's very easy to get obsessed with the details when it comes to taxes. I think, with your help, I've gotten the gist of what I need to do for this year and will give it a shot. Worse comes to worst, I'll find an accountant and go on a budget for a month to make up for the fee!

Each UK bank will send you a statement of interest paid, sometime in late April through June. You can also usually find this amongst the documents that you can access on-line if your bank gives you on-line access (as almost all do these days). You have until 31 January 2017 to submit on-line your UK tax return for the UK tax year 6 April 2015 - 5 April 2016 (or until 31 December 2016 if on paper). You do not have to attach any statements from your bank. The UK operates an honour system. But you know that HMRC are receiving the same information that your bank is providing to you, so they can check your accuracy of reporting if they wish.

HMRC provide a easy-to-use on-line tool for preparing your UK tax return. So there is no need to buy any other software, unless you have very complicated affairs. You can register on their site and thereafter have an up-to-date accounting of what you have paid and owe. This is one of many areas in which UK's HMRC beats the IRS hands-down. (The UK government have even been talking of doing away with tax returns altogether, as they think that someday soon they will be able to collect all the necessary information automatically. I wonder if it is germane that in the US firms like TurboTax have a lobbying presence in Washington.)

As for reporting your bank interest on your US return - you do not need to file any paperwork from your UK bank. So you can do it in January - thought I think most people would wait until the automatic extension in July. Just keep a month-by-month spreadsheet and copies of bank statements. You can add up the 12 payments you have received for calendar year 2015, divide by 0.8, and then report that as your gross interest. Then on Form 1116 (ticked "passive"), you can take a tax credit for the 20% UK tax you have paid. If you are a higher or additional rate UK tax payer, then you will pay more UK tax on this interest, which can also be taken as a credit on Form 1116, though you might not actually pay that tax until you make a "balancing payment" in January 31, 2017. This is where things become difficult, because of two issues: the mismatch of US and UK tax years, and the fact that it is hard to say what tax the UK is actually charging on your interest, and at what date you paid it. Form 1116 expects you to work with either an "accrued" or "paid" basis. Most people use "paid". You can carry-forward and carry-back your UK taxes paid, but at the cost of accountancy complexity.

I have never really figured out the "right way" to handle the above issues on IRS Form 1116. There are experts reading this forum who know much more that I do and might like to chip in. However, one thing I have concluded is that when it comes to completing a US tax return one should stop obsessing that there is a "right way", and that black helicopters will descend if you fail to follow it. If you do something that you can defend, if you are audited by the IRS, as being a good faith attempt to pay the right amount of US tax then perhaps that is enough. For example, if you are a UK 40% rate tax payer you might just claim a credit for 40% UK tax paid on your interest on Form 1116, and leave it at that. With UK tax rates being greater than the US, it is unlikely you owe any US tax on your UK interest (unless some of that were to derive from a UK ISA account paying UK tax free interest).

You could hire a tax accountant who is expert in these things who will complete Form 1116 more correctly, in some sense, - but that could end up costing you vastly more than the few hundred pounds of interest you are might be trying to properly account for on your US tax return. One possibility would be to hire an accountant to help you for at least one year, as a way to learn a method. Another is to do the best you can, and then learn how to do it better if the IRS come back at you with identification of a mistake.

It was another contributor to this forum who once opined, - for the benefit of those who are in danger of being too obsessive -, that there is no unique right way to complete a US tax return.

HMRCs free tax return software cannot prepare the forms required to claim split year residence or non-domicile status.  If one is required to self-assess, tax returns for individuals claiming the split-year basis or the remittance basis can be filed on paper by the earlier filing deadline or online using commercial software.

Moving on to US tax, because the UKs 40% tax band starts at such a low level of income many individuals will be currently subject to UK tax at 40%. Consequently under US domestic law UK interest and UK tax paid on it kicked out into the other income Form 1116. It is no longer passive income. This will all change somwehat for interest credited after 5 April 2016 because of the UK changes in taxation of interest for individuals.

Well done, RW, a good and thorough explanation.

There's also a bit of a tax free element to the US return in the form of the personal exemption and the standard deduction. Of course, it's not necessarily all straightforward, and individual circumstances can vary.

This - if your non-excludable income is not more than your exemptions plus deduction they'll negate the income from being taxable (now if you have more than that then any unearned income will be taxed by the U.S. in the same bracket as if the earned income had not been excluded, unless you can take a foreign tax credit to reduce or eliminate it).